Paulsen: Cocktail of Factors May Spark Inflation Fears In 2014

Could 2014 finally be the year that long-simmering inflation fears boil over? Wells Capital’s Jim Paulsen thinks it just might be.

“In the last five or six years we’ve been worried about nothing but deflation and weak growth,” Paulsen tells Yahoo Finance’s Breakout, “so it’s very difficult to imagine that we might get to a point where we’re worried about an overheated economy again, but I think we’ve got a shot at that (this year).”

Paulsen says a number of factors — a new dovish Federal Reserve chairman, tightening labor market, rising factory capacity utilization rate, rising commodity prices — could combine to trigger inflation fears. “If you put all those together I think that could cause people to worry about overheating or inflation,” he says. To be clear, though, Paulsen is expecting only a small pickup in inflation this year. But he thinks that slight pickup could trigger bigger fears.

Bond Guru Offers Counterpoint to Inflation Argument

Jeffrey Gundlach thinks interest rates will soon rise, but, unlike fellow bond guru Bill Gross, he doesn’t think inflation is upon us.

Gundlach, in a web seminar, recently said that a paradigm shift has occurred in the past five years or so, according to AdvisorOne. “Over the majority of the [past three decades or so] we’ve seen a benign inflation period characterized by stable to falling interest rates,” he said. “It’s quite likely interest rates will now rise and boost the returns of government instruments.” But, he added that inflation can’t occur without corresponding increases in median household income, and he says that is falling, AdvisorOne reports.

But Gundlach is concerned about global food price inflation. “Believe it or not, food is the real concern, especially in developing countries,” he said. “In these areas, 40% of a person’s income will typically go toward food. If it goes high higher, it will have an outsize impact, and riots and other forms of civil unrest could occur.” He also discusses debt, saying that developing nations are “now better fiscal stewards than developing countries”.

PIMCO on Why Inflation Will Rear Its Head

Top fund manager Mihir Worah of PIMCO says not to be lulled into complacency by the low inflation we’ve seen in recent years.

“We expect global inflation over the next three to five years — or even the next five to 10 years — to be higher than it has been over the last 20 years,” Worah says in an interview posted on PIMCO’s site. “While we do not expect double-digit inflation, we do see inflation gradually climbing higher than the close-to-2% core numbers that we have gotten used to in much of the developed world.”

Worah says two main factors lead him to that conclusion: First, the serious debt problem in developed countries will likely be solved only via inflation; and second, a booming middle class in the emerging world could well lead to a secular rise in global commodities prices.

Worah talks about why he thinks inflation will be higher in emerging markets than developed markets, and why significant differentiation could occur within Europe in terms of inflation levels. He also talks about how to hedge a portfolio against inflation, with the core tool being developed market inflation-linked bonds.

Einhorn Ups Bullish Bets, But Warns on Inflation

Hedge fund guru David Einhorn says he increased his bullish bets last month, but remains concerned about several issues, including the Federal Reserve’s low-interest rate policy.

In a conference call with Greenlight Capital Re investors, Einhorn said that he increased his bullish positions thanks to better-than-expected corporate earnings results, Bloomberg reports. But, he added, “This enthusiasm is tempered by our continued concern about the structural sovereign-debt problems in Europe and Japan, a slowing Chinese economy, and high oil prices and general inflation connected to the Fed’s continued insistence on maintaining an emergency zero percent interest-rate policy, which we believe is no longer useful or effective.”

Greenlight Re’s investment portfolio’s net-long position rose to 39% in April from 32% at the end of March, Einhorn said. He said he also added short bets in the first three months of the year as the market rallied, according to Bloomberg.

More On Inflation And Asset Allocation

Last week, we highlighted a MarketWatch column that referenced a new study showing that stocks, against conventional wisdom, have actually served as poor hedges during periods of marked inflation. But a closer look at the study shows that that is far from the whole story.

The study was performed by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School, who over the years have performed some of the most in-depth research ever on asset prices. Their latest effort looks at 19 different markets since 1900, examining how different assets performed during periods of “marked” inflation. They found that bonds — not surprisingly — get crushed in such periods, averaging a real return of -23.2%. Stocks, however, also struggle, they found, losing an average of 12% in real terms.

That sounds troubling, especially given how stocks are generally considered to be good inflation fighters. But if you look at Dimson, Marsh, and Staunton’s analysis (which is part of a Credit Suisse report), there’s a lot more to the story. For one thing, in their study, “marked” inflation signified inflation of at least 18% annually — a very steep figure that the U.S. didn’t even reach during the sky-high inflation of the late ’70s/early ’80s.

So how have stocks fared when inflation has been high, but not at that 18% mark? Well, according to the professors, when inflation has been between 8% and 18%, stocks haven’t fared great, but they’ve remained ahead of inflation, with 1.8% average annual real returns. Bonds, on the other hand, have averaged real annual losses of 4.6% in those periods. And, when inflation has run between 4.5% and 8%, stocks have produced annual real returns of 5.2%, while bonds have barely eked out a positive return.

Gold, meanwhile, has been a good hedge in those periods when inflation has been at least 18%, with real returns that were just in positive territory. In the 8% to 18% inflation range, gold has also outperformed stocks, with real returns of 4.4%. In that 4.5% to 8% inflation range, however, gold has produced real returns of just 2.8%.

But Dimson, Marsh, and Staunton warn against using inflation data as a timing signal, particularly since investors don’t know what the inflation rate is for a particular period until the period is over, and asset prices have already moved. “This is not a market timing tool,” they write. “High inflation may look like a sell signal, but our model is derived with hindsight and could not be known in advance; there is clustering of observations, so many of the signals may occur at some past date (e.g. the 1920s); and it is not clear where sales proceeds should be parked. In particular, real interest rates tend to be lower in inflationary times, the expected real return on Treasury bills will be smaller after an inflation hit, and other safe-haven assets like inflation-linked bonds are likely to provide a reduced expected return in real terms.”

Click here for a PDF copy of the professors’ report, which includes in-depth analysis of how inflation has impacted a number of asset classes over the past 112 years.

 

An Industry That Can Beat Back Inflation

In his latest column for RealMoney.com, Validea CEO John Reese says inflation can be a big hindrance to good investing returns, and highlights one industry — pharmaceuticals — that has the power to beat back inflation.

“If inflation were Wile E. Coyote then its Road Runner might well be the pharmaceutical industry,” Reese writes. “An AARP study found that of drugs used most by older Americans, prices rose nearly 26% from 2005 to 2009, which was close to twice the inflation rate.” He cites a New York Times article that notes that when a drug does not face any competition, “its maker can charge almost any price (and) once a company sets a price, government agencies, private insurers and patients have little choice but to pay it.”

“Nice,” Reese writes. “Wouldn’t we all like such pricing leverage? We can by investing in pharmaceutical companies and riding their pricing power.” He examines three stocks from the industry that get high scores from his Guru Strategies, each of which is based on the approach of a different investing great. Among them: Questcor, which gets high marks from his Martin Zweig-inspired strategy.

Are Stocks Really A Good Inflation Hedge?

Conventional wisdom is that stocks are a good hedge during inflationary periods. But some prominent financial researchers say the belief is off the mark.

“When inflation has been moderate and stable…equities have performed relatively well,” Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School write in the 2012 Credit Suisse Global Investment Returns Yearbook, according to MarketWatch’s Howard Gold. “When there has been a leap in inflation, equities have performed less well in real terms,” the professors say. “These sharp jumps in inflation are dangerous for investors. … High inflation reduces equity values.”

Gold notes that the professors found that, during periods of “marked” inflation, equities far outpace bonds, which average a dismal -23.2% real return during such periods. But while equity returns are better, they aren’t good in real terms, averaging -12%.

Over the long term, several strategists, including David Dreman, have shown that inflation eats away tremendously at the returns of bonds. Stocks, in contrast, tend to generate higher nominal overall returns (and companies behind the stocks have the ability to pass some costs on to consumers during inflationary times), so inflation eats away a much lower portion of those nominal returns over the long haul.

But Gold notes that even Wharton Professor and Stocks for the Long Run author Jeremy Siegel, a big proponent in investing in stocks for the long term, has acknowledged stocks’ lack of short-term inflation-beating power. “Over 30-year periods, the return on stocks after inflation is virtually unaffected by the inflation rate,” Siegel wrote in Kiplinger’s last year. “Although stocks do well when annual inflation is in the range of 2% to 5%, their performance begins to falter when inflation exceeds 5%.” That’s because “companies can’t always pass along increased costs, especially in the case of an important raw material, such as oil. As a result, many companies will see their profits squeezed.” Siegel says that “stocks are not good short-term hedges against rapidly increasing inflation, but bonds are worse.”

Dimson, Marsh, and Staunton say that “gold is the only asset that does not have its real value reduced by inflation,” though they add that gold “has generated volatile price fluctuations … There have been long periods when the gold investor was ‘underwater’ in real terms.” They also say that housing is a good hedge against inflation.

 

Buffett: Productive Assets Like Stocks Offer Most Safety — Not Bonds

Over the past few years, investors have poured into low-yielding Treasury bonds, perceiving them as the safest place to be during the global economic tumult. But, according to Warren Buffett, bonds are one of the most dangerous places for investors to put their money over the long term — and that’s not going to change.

“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period,” Buffett writes for Fortune magazine in a piece billed as an adaptation of his upcoming annual letter to shareholders. “Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And … a nonfluctuating asset can be laden with risk.”

The risk for bondholders — and investors in other currency-denominated assets like  money market funds or bank deposits — comes in the form of inflation. Buffett says that throughout history, inflation and income taxes have eaten away at bond returns. And, today, with bond yields so low, “Right now bonds should come with a warning label,” Buffett says.

Since he took over Berkshire Hathaway in 1965, the purchasing power of the dollar has fallen 86%, Buffett says. Continuous rolling of Treasury bills over that period would have produced a 5.7% average annual return, he notes — but 4.3 points of that would have been eaten away by inflation. The other 1.4 points would have been lost to income taxes, he adds.

Buffett says he doesn’t like currency-based investments like bonds right now, though for liquidity reasons Berkshire owns substantial amounts of them.

Buffett also is lukewarm on another class of assets — those “that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future.” Gold is the biggest example, and, while he doesn’t explicitly say it, Buffett hints at the idea that gold may be in a bubble right now, driven higher by fear and crowd-following. In general, he is skeptical of gold because it doesn’t produce anything or grow in size the way that a company might.

The third main category of investments — his preference — is “productive assets”, Buffett says, citing businesses, farms, and real estate. “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment,” he says.

Over the long term, the ability to keep pace with — and, in fact, grow faster than — inflation makes productive assets the place to be, Buffett says. “I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined,” he says. “More important, it will be by far the safest.”

Deflation Could Help Us, Trahan Says

Highly-rated strategist Francois Trahan says that “deflation” is not a dirty word, and that the Federal Reserve could help the economy by allowing deflation to stem commodity price inflation that is “eroding people’s pockets”. Trahan says Fed members and other policymakers and economists are relying on economic principles that aren’t relevant right now. Three main things are making the economy fundamentally different today than it was years ago, he says: consumers are deleveraging; governments are cutting payrolls; and the Federal Reserve has become ineffective. His outlook for the economy is “atrocious”, he says, and he advocates a cautious, safety-first investment approach right now.

Arnott on Why the Valuation Picture Is Troubling

Interest rates and inflation have a much greater role in stock market valuations than you might think, and that means the stock market is on a “very dangerous” path, according to Rob Arnott.

In an article for Morningstar, Arnott, of Research Affiliates and PIMCO, looks at the relationship between stock market valuation levels, interest rates, and inflation. His findings: More than half the variability in P/E ratios over the past 140 years can be explained by changes in real interest rates and inflation. “Modest — or even moderate — inflation seems to have a benign impact on valuation multiples. Modest — or even moderate — positive real interest rates seem to have similarly benign consequences. Indeed, with real rates and inflation ranging from 1–5%, the average Shiller P/E ratio hovers around 22 times 10-year smoothed earnings, give or take a mere 15%.” But, he adds, “P/E ratios fall off a cliff outside of this range.”

Currently, the Shiller P/E (which averages earnings over the past ten years) is around 20. Trailing three-year inflation is about 1% per annum, and the 10-year Treasury bond yields about 2.0%, meaning that the “real yield” is about 1%. Historically, when inflation and real yields are both in the 1–3% range, the Shiller P/E averages about 19, Arnott says, so the current level is only slightly higher. “But,” Arnott says, “this arithmetic misses something important: radical changes in the way the federal government calculates the Consumer Price Index.” Official data shows that the current inflation rate is about 3% to 4% lower than it would be using the old method, he says. Using a more conservative estimate of a 2% difference, history suggests the Shiller P/E should be about 18 right now. And, importantly, the market gets closer to falling off the edge of its “valuation sweet spot”.

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